Question

It is often easy to overlook the impact of inflation on the net present value of the project. Not incorporating the impact of inflation in determining the value of the cash flows of the project can result in erroneous estimations.

Consider the following scenario:

Praxis Corp. is considering opening a new division to make iToys that it expects to sell at a price of $13,575 each in the first year of the project. The company expects the cost of producing each iToy to be $6,700 in the first year; however, it expects the selling price and cost per iToy to increase by 2% each year.

Based on this information, select the correct answer:

Selling price in year 4:	__________
Cost per unit in year 4:	__________

If a company does not take inflation into account when analyzing a project, the expected net present value (NPV) of the project will typically be (lower/higher) than the true NPV of the project.

Answer 1

Selling Price in Year 1 = $13,575

Cost per unit in Year 1 = $6,700

if = Inflation rate = 2%

Selling Price in Year 4 = Selling Price in Year 1 * (1+if)^3

= $13,575 * (1+2%)^3

= $13,575 * 1.061208

= $14,405.8986

= $14,405.90

Cost per unit in Year 4 = Cost per unit in Year 1 * (1+if)^3

= $6,700* (1+2%)^3

= $6,700 * 1.061208

= $7,110.0936

= $7,110.09

Selling price in year 4 is $14,405.90

Cost per unit in year 4 is $7,110.09

If a company does not take inflation into account when analyzing a project, the expected net present value (NPV) of the project will typically be Lower than the true NPV of the project. since inflation will increase the cash flow